Volcker Rule Implementation 2. Proprietary Trading

The provisions of the Volcker Rule mean that banks are “turning their attention to difficult decisions that must be made,” said Anna Pinedo, Partner at Morrison & Foerster and the second of two speakers during a GARP webinar on April 1, 2014.

The Volcker Rule defines proprietary trading as a bank “engaging as principal for” its own “trading account” in a “purchase or sale of one or more financial instruments,” including derivatives, noted Pinedo.

Pinedo reviewed the financial instruments that must be assessed for compliance with the new rule. “A lot of our clients itemized and inventoried products to determine which swaps and securities were affected.”

“If an instrument is held for less than 60 days, it’s assumed to be proprietary trading,” said Pinedo. “Unfortunately, the reverse does not apply, for instruments held over 60 days.”

A trading account can be scrutinized with three sets of criteria: purpose test, market risk capital test, and status test, said Pinedo. She listed trading activities that were not considered proprietary trading, such as repo/reverse repo transactions on slides 18 to 20 of the downloadable presentation.

The Volcker Rule allows hedging that is “specifically focused on mitigating identified risks,” said Pinedo, “but not hedging of generalized risks.” [See slides 22 to 24 for details.]

The Volcker Rule permits market-making activities. A market maker is an entity that is “routinely standing ready” to purchase and sell financial instruments. She praised the preamble to the Volcker Rule for showing awareness that market-making in “illiquid securities may look different than frequently traded equity securities.” [See slides 25 to 28 for details.]

The Volcker Rule permits underwriting “only if the trading desk’s underwriting position is related to a distribution of securities for which the bank is an underwriter,” Pinedo noted. [See slides 29 to 31 for details.]

The Volcker Rule prohibits trading that could result in a material conflict of interest between a bank and its clients, or that unduly exposes the bank to a high-risk trading strategy, or one that could pose a threat to US financial stability.

It’s a tall order to spell out all the details and prove compliance. The new rule will keep compliance personnel busy for years. Banks are in danger of “losing flexibility since they must have a plan and document their activities so thoroughly,” she said.ª